Interview

The Value Gene

Paul Isaac's father helped Mutual Shares founder Max Heine find his first job on Wall Street. And his uncle, Walter Schloss, studied under Benjamin Graham and was praised by Warren Buffett. Why Isaac likes French banks and is down on Amazon.com.

Thank You

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This New York-based investor has value investing in his blood. His father, Irving, an arbitrageur, was instrumental in finding Max Heine his first job on the Street. Heine went on to run the legendary Mutual Shares Fund, and Irving Isaac sat on its board for three decades. And Paul Isaac's uncle, Walter Schloss, a student of Benjamin Graham, was praised by Warren Buffett and profiled in Barron's. At his former position leading a fund of funds, Paul Isaac produced high single-digit returns annually. That fund was sold after the 2008-2009 financial crisis. He continues to manage Arbiter, a hedge fund that has returned 21% a year, on average, since its 2001 inception. Isaac, 62, writes nuanced, beautifully reasoned investor letters that magnificently illuminate the financial markets. One fan is writer and investor Jim Grant, who once dedicated a book thusly: "To Paul Isaac, who knows everything." To learn Isaac's take on the world and what Irving and Walter might think, read on.

Barron's: How is your style different from Walter's or your father's?

Isaac: I'm a value-oriented investor with a preference for tax efficiency. In an ideal world, you want good management with a strong sense of capital stewardship in strong business franchises with good growth prospects at low prices. I like statistically cheap securities trading at appreciable discounts to tangible book, but I will not buy such securities primarily on their discounts from book.

I am much more aggressive than my father, who had as much as one-third of his partnership in T-bills. I invest in foreign securities, which he rarely did. I take short positions, buy stressed fixed-income securities, and invest in financials. Walter rarely did any of that. He was very much a balance-sheet fundamentalist. He didn't have a lot of contact with management and often avoided management.

My father and Walter did not agree. My father was even more conservative. He started out as an arbitrageur. His specialty was the breakup of the public utility holding companies in the mid-1930s. He had more of a sense of an internal corporate strategy and was interested in special situations. He was more conscious than Walter of qualitative issues.

What would they say about this market?

Walter retired [in 2002], in part because he felt the markets had gotten crazy and ebullient, and that there would be a pretty difficult extended period. At his age, what was the point of sticking around?

My father graduated from NYU in 1928. When he studied economics, everyone was focused on the very sharp depression at the end of World War I. He would likely have seen the Great Recession as the long-delayed product of a series of palliative measures, starting with the relative lack of a post-World War II adjustment to a peacetime economy.

You sometimes describe yourself as a farmer on Mount Vesuvius. Please explain.

We have better-quality, bigger companies than we've ever been involved in before. The market tends to have a different curve of valuation for big companies versus small companies, growth companies versus companies that aren't growing so fast. Ironically, a lot of larger companies are relatively inexpensive on a historical basis. Some are downright cheap, with strong market positions, reasonable franchises, and good free-cash flows. In many cases the balance sheets have been improved. All this takes place against the backdrop of an unresolved set of structural economic issues in the U.S. and globally. What ultimately will precipitate a major confrontation with these issues, and how will the financial markets be affected?

What is the answer?

I lived through the early part of 1994 when you had a bloodbath in the long bond. What happens if U.S. policymakers are forced by external pressures to make hurried and extemporized changes in fiscal policy that affect 2% to 4% of gross domestic product? What kind of administrative measures and capital controls might be parts of such political packages? What might that mean for the ground rules of markets and the free flow of capital?

Isaac's Picks

Recent

Company

Ticker

Price

Bolloré Group

BOL.France

€180.95

Devon Energy

DVN

$54.65

Greif Brothers B

GEFB

$47.50

...and Pan

Amazon.com

AMZN

$215.36

Source: Bloomberg

You could wind up with a liquidation-only situation in which banks are unable to effect foreign-exchange transactions if you want to invest overseas. Given the lack of coherent policy generally, it could get ad hoc and unpredictable.

How are you feeling about Europe?

The Europeans are generally muddling through. From the point of view of economics, they are actually addressing their problems more than we are. The question is: Are they addressing it sufficiently? The Spaniards have made real efforts to reduce their budget deficits. The question is whether the current Spanish government will exhaust the patience of its electorate before it can really get the job done. We have the same problems, and the Japanese have it worse. These big fiscal deficits have to be funded, and are being funded because the banks have to use a chunk of their balance sheet for theoretically riskless liquid assets. You're building a problem that could ultimately become a major issue in banking systems. In Europe, you could string this thing out for several years.

When do we return to prosperity?

Define prosperity! We are above the aggregate real economic activity of '07, so by that standard definition, the recession is over. We have slack labor markets. But real global GDP has grown by something like 15% to 20% since the '08 financial crisis. The question is about another boom where there is a generalized feeling that everybody's situation is getting better. That may not occur for a decade.

The market is affording you reasonable real returns. The name of the game here is to keep on going in a reasonable low gear, position yourself not to get knocked out of the game if we have an interim crisis like another 1994, or a political breakdown in Europe that propagates more severe fears in the financial system, or a crisis of confidence in Japan's banking system. I'm also in the bear camp on China. I don't think we can assume the authorities can always contain another set of serious problems.

But from an investment perspective, a number of European companies have a fair amount of risk, but are extremely cheap and probably immune to failure risk. They present pretty good alternatives in terms of places to invest.

These are conservatively run regional banks. France didn't have a gigantic real- estate boom. If you don't think the French banking system is completely imploding, these are really cheap certificates, and you are paid a fair amount while you wait. In 2009, two regional banks bought back all the certificates at 80% of book—two to three times the present price. A number have active buyback programs, in some of which the shares are permanently retired and in some of which they are part of "liquidity programs."

What else?

We have a position in
Bolloré Groupbol.fr -1.018370607028754%Bollore S.A.France: ParisEUR4.957
-0.051-1.018370607028754%
/Date(1427841494000-0500)/
Volume (Delayed 15m)
:
3677280
P/E Ratio
N/AMarket Cap
14444416350.9295
Dividend Yield
N/ARev. per Employee
197806More quote details and news »bol.frinYour ValueYour ChangeShort position
(BOL.France), a large European conglomerate. Vincent Bolloré is best-known for active positions in a number of large companies, most recently
Vivendiviv.fr 0.10822510822510822%Vivendi S.A.France: ParisEUR23.125
0.0250.10822510822510822%
/Date(1427841300000-0500)/
Volume (Delayed 15m)
:
9786360
P/E Ratio
20.833333333333332Market Cap
31256206266.16
Dividend Yield
4.324324324324325% Rev. per Employee
672600More quote details and news »viv.frinYour ValueYour ChangeShort position
(VIV.France), where he is joining the board. He is a talented guy. The book values of these companies compounded at a mid-teens growth rate for 20 years. Two things are attractive and overlooked. One, a very large ports and logistics operation, primarily in Francophone Africa, that will probably have an operating profit of €500 million this year. Two, the structure of the group is not generally understood. The actual economic float is significantly less than the stated float: Only 40% of the stated share count is outstanding, and they continue to shrink it.

We are buying something that is really inexpensive and compounding asset value at a decent rate. This comes back to my initial point. Usually, things aren't cheap if there's a readily visible exit. But given the talent and track record of the group, we hope to realize reasonably fair value. The group has been spending $200 million a year developing automobile batteries and has a venture in Paris with a kind of Zipcar system that uses electric cars, vans, short-haul buses, that sort of thing. They are talking about taking that public. There is some speculation that the business might be worth $1 billion. We count it at zero. The company is probably trading at a 25% to 30% discount to the stated valuation. Adjusting for the true float outside the various quoted companies and affiliates, the discount is 65% to 70%.

What do you like at home?

Devon EnergyDVN -0.6588700378850272%Devon Energy Corp.U.S.: NYSEUSD60.31
-0.4-0.6588700378850272%
/Date(1427835650913-0500)/
Volume (Delayed 15m)
:
3062542AFTER HOURSUSD60.31
%
Volume (Delayed 15m)
:
70579
P/E Ratio
15.307883648916189Market Cap
24830389625.5493
Dividend Yield
1.5917758249046592% Rev. per Employee
2659850More quote details and news »DVNinYour ValueYour ChangeShort position
(DVN). The company has done a great job of capital allocation and managing its capital structure. It has a great long-term track record of growing cash flow. There is still a disparity between natural gas and oil that is probably two to three times larger than the historical average. That is likely to close. The economics of drilling don't make sense at current gas prices. The Street targets in the high $70s to mid-$80s are reasonable. There is considerable upside in a more normal range of sustainable natural-gas prices, and it wouldn't be hard to see the shares at $110 to $125.

We have a sizeable position in the B shares of
Greif BrothersGEFB -0.3047930283224401%Greif Inc. Cl BU.S.: NYSEUSD45.7601
-0.1399-0.3047930283224401%
/Date(1427834047985-0500)/
Volume (Delayed 15m)
:
2017
P/E Ratio
25.11944886644343Market Cap
2025502890.48569
Dividend Yield
5.506980972506616% Rev. per Employee
316113More quote details and news »GEFBinYour ValueYour ChangeShort position
(GEFB), a packaging company with a nice long-term track record. The A shares are in a bunch of indexes. The B shares, largely controlled by the founding family, are not only voting shares, but also are entitled to 150% of the earnings and dividends on the A shares. The B shares are nine times earnings and pay a 5% dividend. They trade at a discount because they trade at a fraction of the volume of the A shares. Greif has some interesting growth initiatives in liquid packaging. It is buying back the B shares.

What do you dislike?

We are short
Amazon.comAMZN -0.66472676793294%Amazon.com Inc.U.S.: NasdaqUSD372.1
-2.49-0.66472676793294%
/Date(1427835600307-0500)/
Volume (Delayed 15m)
:
2354772AFTER HOURSUSD372.65
0.5499999999999540.14780972856758937%
Volume (Delayed 15m)
:
P/E Ratio
N/AMarket Cap
173953601865.354
Dividend Yield
N/ARev. per Employee
577469More quote details and news »AMZNinYour ValueYour ChangeShort position
(AMZN). Now that the book and media business is being digitized, their platform is less unique, and at the same time, they're competing in general merchandise, which will be difficult to convert into substantial profitability. I wouldn't be tempted to buy it, even at $100 a share. The nature of its free cash flow is misunderstood. Amazon generates a lot of cash from its negative working-capital cycle, which funds the build-out of physical facilities to support logistics and fulfillment. In a sense, it borrows short from customers and uses that money to fund long-lived capital assets.

Rapid sales growth masks this process. Broad-based stock-option compensation requires an appreciating stock. Amazon may need to "buy" sales. It dismounts from that treadmill at great risk to its model.